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March 20, 2006

Everything Looks Good at the Top of the Channel

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Technical update: Market “technicians” recognize that the major indices are performing well here, and they're generally right. “Internal” market action is less compelling, though. For example, while breadth, as measured by advances versus declines, looks reasonably good, leadership and follow-through have been waning on each successive rally (witness, for example, the declining number of stocks above their 20, 50 and 200-day moving averages, despite marginal new highs in the indices), and the picture is even less compelling if one analyzes trading volume and other measures of sponsorship. For investors who like Bollinger Bands, it's notable that the Dow, S&P and Russell 2000 indices are all at the very top of very extended advances in the daily, weekly, and even monthly bands.

So while the market appears reasonably firm from the standpoint of the major indices, it also appears to be strenuously overbought. The total return on the S&P 500 remains behind lowly T-bill returns for the period from July 1998 to the present (less than 3% annually). The Russell 2000 – by far the strongest index during this period – has achieved less than 8% annually in total return since then. Even a modest decline would wipe out the advantage that the S&P has enjoyed over T-bills over the past two years. New highs can be enticing, so it's useful to keep them in perspective.

Fundamental update: With the latest reports in, S&P 500 earnings now stand at a fresh record. While it's tempting to extrapolate the growth trends of the past few years in hopes of further earnings gains, it's sobering to examine exactly where S&P 500 earnings are from a long-term perspective.

Notice that despite the recent hype, the long-term picture is unchanged. Earnings for the S&P 500 have now moved simply to the 6% long-term growth trend that has connected prior cyclical peaks in earnings for over a half-century (that trend actually goes back much further). Again, everything looks good at the top of the channel.

Based on the most recent (record) figures for trailing net earnings, the S&P 500 now trades at a price/earnings ratio of 18.3. From the standpoint of the past decade or so, that doesn't seem to be a very threatening valuation. The problem is that the past decade or so represented the most extended valuation bubble in history, and a denouement that, even including the 2000-2003 bear market, never included a period of historically normal valuations.

Normal Valuations

Over the long-term, the average price/earnings ratio for the S&P 500, based on net trailing earnings, has been about 15 (importantly, most of that history was characterized by interest rates and inflation at or below current levels). Never slander this “15” figure by quoting it anywhere in the vicinity of P/E ratios based on “operating earnings,” or “forward operating earnings.” Those latter earnings figures are typically substantially higher than net trailing figures, producing commensurately lower P/E ratios. Though the whole concept of “operating earnings” was created in the past couple of decades (abandoning generally accepted accounting principles in order to exclude anything – I mean anything – that might make earnings less predictable), it's safe to conclude that “normal” P/Es based on operating earnings should be a whole lot lower than 15.

The same is true if we look at the chart above. Notice that most of the time, S&P 500 earnings have been substantially below that 6% growth line that connects historical earnings peaks. So you might guess that the average historical P/E, when earnings have been at the top of their channel, would probably have been something less than 15.

And you'd be right. Excluding the late 1990's bubble peak, the price/earnings ratio for the S&P 500, when earnings have been within 5% of that top channel, has historically averaged just 9.0… again, the current multiple is 18.3. Makes you think.

Even if we look at a larger number of periods since 1950 where S&P 500 earnings were anywhere within 20% of that top channel, we still find that the average price/earnings ratio for the S&P 500 was just 10.6.

That's important, because that 2-to-1 comparison between current and normal P/E ratios is about what we observe when we compare current and normal price-to-book and price-to-dividend ratios. That's not to say that stocks are about to drop in half. But it most definitely implies that stocks are currently priced to deliver nowhere near the returns they historically have. It's a point that I've made often, and is one of the reasons why, despite marginal new highs in the major indices, an emphasis on risk management here is not likely to impair long-term returns.

Economic Fundamentals

As I noted in the latest semi-annual report, it's also of concern that real wages have been rising faster than productivity in recent reports. The current, elevated level of earnings is based on unusually wide profit margins, which historically have not tended to persist. The reason for the wide profit margins is the low share of revenues being paid as wages and salaries. That's beginning to change. Real wages represent amount of “real” goods and services that employees effectively take with them through their paychecks. To the extent that real wages rise faster than productivity (the amount of goods and services those same workers produce), profit margins are pressured lower. Given that earnings are already at the top of a very robust historical channel, it seems unlikely that we'll observe more than tepid earnings growth in the coming few years.

Meanwhile, hope springs eternal that the end of Fed rate hikes will be favorable for stocks. Maybe, but as noted in earlier weekly comments, there's no historical evidence for that. My impression is that Ben Bernanke will face far more problems than Greenspan did. Greenspan's success as a Fed Chairman was actually based on two conditions: 1) fiscal discipline, and 2) the willingness of China and Japan to swallow as much government debt as we were able to dish out (in their attempt to support the U.S. dollar relative to their own currencies). Indeed, foreigners continue to buy about $2 billion in U.S. securities a day, which we observe as our “current account deficit.”

Bernanke inherits none of the favorable conditions Greenspan enjoyed. Rather, fiscal policy is out of control, and we're actually trying to get China and Japan to stop supporting the U.S. dollar. To the extent that we succeed, or the appetite of foreigners for U.S. debt slows down in the least, those government liabilities (money and bonds) will have to be absorbed by U.S. investors, resulting in either higher inflation and interest rates, or a crowding out of domestic investment. Most likely, whatever growth we see in capital spending from here will come at the expense of housing investment.

So while the surface, “high frequency” data seem to support a rosy picture for the stock market and the economy, the deeper, “low frequency” fundamental conditions are much less favorable. As long-term investors, that low frequency stuff (factors that affect the behavior of the economy over a period of years, rather than days or weeks) is important. Yes, the short-term performance of stocks looks good, and the economic data is still hanging in reasonably well. But then, everything looks good at the top of the channel.

Thought is not action

There's a quaint idea that has emerged in analyst talk these days, which basically goes “concerns about valuations, the current account deficit and other things aren't really important, because everyone has already looked at them, and markets don't usually respond to things that investors have already considered.”

It's a nice idea, but it's preposterously wrong. It isn't the mere consideration of a risk that makes it benign. Rather, risks become benign only when investors have already acted on them. Anyone who remembers the 2000 market peak (from which, as it happens, the S&P 500 has still earned a zero total return after 6 years) will recall that rich valuations were very well recognized, but investors suspended or delayed acting on those valuations by reducing their speculation. For a known risk to become benign, you have to act on it and price it in. It's not automatic. Thought is not action.

Simply put, the main risks to the market generally are ones that investors have considered, but are also ones that they have not acted on. If you're a window-washer and know that your platform is slippery, thinking about it isn't enough to eliminate the risk. What makes the risk benign is that you tie a rope around your waist. The fact that investors have “considered” valuations, the current account deficit, and other matters doesn't in the least make those risks less important, because investors have not acted on those risks in any meaningful way.

Market Climate

As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and relatively neutral market action. As noted above, market action appears firm in the major indices, but internal conditions are less compelling. Hence the neutral overall condition. The Strategic Growth Fund remains fully-hedged against the impact of market fluctuations here, but it's possible that we would accept a modest amount of market exposure (say, as much as 20-25%) if we were to observe a general market pullback without much deterioration in market internals. For now, with the markets clearly overbought, the case for increasing our market exposure isn't very convincing.

In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable market action. The Strategic Total Return Fund continues to carry a duration of about 2 years (meaning that a 100 basis point change in interest rates would be expected to affect Fund value by about 2% on the basis of bond price fluctuations), and a recently increased exposure to precious metals shares near 15% of assets.

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